OPINION: SA economy grinds lower in a low inflation environment

JOHANNESBURG - Industrial production accounts for just below 25percent of gross domestic production (GDP), but as the components (manufacturing, mining and electricity production) are primary or secondary sectors, they impact the tertiary sector and tend to have a meaningful relationship with economic growth.

In Q1.18 (first quarter of 2018) industrial production contracted by 8.3percent in the quarter seasonally adjusted annualised (qqsaa), with GDP contracting by 2.2percent qqsaa. South Africa’s industrial production figures to date show a 6.2percent qqsaa contraction for the first two months of Q2.18 (second quarter 2018, plus March 2018 as the June figures are not yet out).

The risk is that this trend continues for the last month of Q2.18, contributing to another negative quarter, and risking recession. Without agriculture, GDP would still have contracted in Q1.18, by 1.6percent qqsaa.

For industrial production to record a flat to positive contribution to Q2.18, and so assist South Africa to escape a recession in the first half of this year, requires mining production to rise by 3.8percent m/m sa, seasonally adjusted, in June, if manufacturing and electricity production stay flat on the month in June, or increase.

The good news is that the leading indicator, which has a fairly significant relationship with GDP six months out, predicts that Q2.18 will improve over Q1.18, even if economic growth is not particularly robust. In particular, the relevant indicator shows that the volume of orders in manufacturing rose, as did the commodity price index for South Africa's main export commodities.

Mining production has performed poorly this year, even excluding gold production. The production of iron ore (heavily weighted component) and coal (the most heavily weighted component) generally underperformed on a year ago, along with platinum group metals (second highest weighted category), despite higher commodity prices, on a malaise in much of the sector.

Uncertainty

Ongoing regulatory and policy uncertainty is perceived to have disincentivised much of the impetus for new fixed investment, and the construction of mines have generally fallen in total since 2010, along with real and nominal net investment (investment excluding depreciation costs of assets) into the sector (Data source: Minerals Council of South Africa).

South Africa's mineral sector is ranked worse than most in the world for investment attractiveness (legislation, regulation, operating environment and best practice policy) by the Fraser Institute for 2017.

If South Africa rose to better rankings, fixed investment into its mining sector would likely rise, and with it new mines and jobs, in turn supporting higher economic growth. With mines ageing in South Africa, or seeing reduced production and/or closing, new exploration and ultimately new mines are needed, and in particular, legislative and policy support is needed to attract this investment.

The Minerals Council of South Africa estimates that a new (underground mine) costs between R3billion and R10bn, with investment key in the exploration stage.

The council further shows that South Africa only attracted 1percent of global expenditure on mineral exploration in 2017.

A 10percent free carry on new mines, in an already relatively unattractive investment environment, clearly increases investment costs, causing South Africa to slip further in attractiveness as an investment destination on lower returns and ownership. With the other side of the coin showing workers negotiating for higher wage increases on escalating living costs over the past several years, many mines, which are not easily making a profit, if at all, will not be able to meet these wage demands - with all parties also wishing to avoid the crippling strikes of several years ago.

The third member of the partnership between labour, business and the government needs to offer mines significant regulatory and tax relief (ie the government), particularly for new mines and those in exploration stages, in order to provide support to the sector, and so to jobs in the sector.

Without meaningful government support to increase the attractiveness of private sector fixed investment in the mining sector going forward, the sector could shrink substantially, and further material job losses occur. In this regard (stimulating large-scale private sector investment), iterations of the Mining Charter have so far failed.

With Eskom also facing higher wage negotiations, while its finances are in poor shape, the heavily over-borrowed entity reportedly faces hard choices in terms of large retrenchments versus repairing the health of its finances.

The state-owned enterprises will also struggle to meet electricity demand of an economy growing at a 3percent year-on-year (y/y) rate, let alone one at 5 to 6percent y/y growth.

Not much support is expected from electricity production from a GDP growth (seasonally adjusted) point of view in Q2.18 with load shedding being reinstituted, while the sector battles to deliver new supply anywhere close to initially scheduled time frames. Corruption is also seen to have damaged South Africa's electricity production sector.

Positive contribution

Manufacturing production is expected to deliver a positive contribution to GDP in Q2.18, especially as agricultural production has been performing better than expected, and so could likely boost food manufacture. Indeed, the agricultural sector itself potentially could make a positive contribution to GDP in Q2.18, and has assisted lower than expected inflation outcomes.

However, the manufacturing sector has seen marked de-industrialisation as its contribution to GDP has declined, from 23percent in the 1980s, to around 13percent recently. Indeed, South Africa has lost significant competitiveness globally, with the World Economic Forum revising down South Africa's rating considerably in recent years as well in its global competitiveness report.

Along with its competitiveness and institutional strengths, South Africa has seen its credit ratings deteriorate substantially in the past few years, to an average of sub-investment grade from the three key credit rating agencies. The governance of the state owned enterprises and state institutions is also seen to have deteriorated substantially over the past several years.

Real household income growth and the efficacy of corporate boards has also deteriorated and corruption risen.

The International Monetary Fund warns that economic growth in South Africa will not lift above 2percent without resolving uncertainties surrounding land expropriation without compensation (in a way that does not detract from business confidence) and instituting outstanding structural reforms.

However, the recent passing of the expropriation bill by Parliament, and signing of the Protection of Investment Act, are both seen to disincentivise domestic fixed investment and foreign direct investment, by weakening private sector property rights.

Should 2018 growth disappoint, and 2019 look to do the same, key credit rating agencies have warned that South Africa could face further credit rating downgrades.

There is a risk for South Africa that GDP may disappoint in Q2.18, leading to a lower 2018 outcome than currently expected, with the latest figures (to May) showing that retail sales fell -0.4percent qqsaa.

Lower sovereign credit ratings would both increase South Africa's cost of borrowing and lower its ease of borrowing, in an environment where the country is already battling fiscal consolidation, particularly given recent higher-than-budgeted-for civil service wage settlements, rising government debt/GDP and now even considerations of reversing the VAT increase.

Annabel Bishop is Investec’s chief economist.

The views expressed here are not necessarily those of Independent Media.